Quant Investors Left Reeling as a Booming S&P 500 Trade Misfires

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Before things went south, Bastian Bolesta made easy money from a quant strategy that worked for years thanks to the rise of automated stock traders on Wall Street.

If S&P 500 futures rise, his trading program goes long. If the index drops, it duly puts on a short. Then the money manager just waits for the 4 p.m. bell and closes the position. And repeat.

Known as intraday trend-following, systematic players like Bolesta have long exploited one-way trading patterns in the world’s most-watched stock index.

But in 2020, the strategy posted the worst decline in two decades -- seemingly out of nowhere. With no sign yet of a spirited revival, quants are trying figure out what’s causing this once reliable options-powered trade to misfire.

Quant Investors Left Reeling as a Booming S&P 500 Trade Misfires

“We still saw some large moves intraday, but they were choppy,” said Bolesta, chief executive officer at Switzerland-based Deep Field Capital with $105 million.

The strategy has been faring better in Asian and European benchmarks, he said. But something weird is happening in the underbelly of the S&P, where the likes of exchange-traded funds and index funds trade billion of dollars in stocks on autopilot in the dying minutes of each day.

It takes advantage of the well-known smile, or smirk, pattern in stock volumes, which tend to surge after the open and even more right before the close. More recently the retail investing frenzy has shifted the activity, with day traders more likely to jump in during the first half of the day.

The intraday strategy’s gained new fans outside a niche band of quants as investment banks including Societe Generale SA package momentum-chasing products for institutions.

Quant Investors Left Reeling as a Booming S&P 500 Trade Misfires

Yet a Deutsche Bank AG index tracking the trade has declined 11% from its April peak -- an unprecedented slump. Similar indexes from Credit Suisse Group AG, Macquarie Bank and Morgan Stanley tell the same story.

“The bleed seems to be significantly higher than it has been historically,” said Sorin Ionescu, a quant at Deutsche Bank, referring to losses for the strategy.

One theory holds that the release of big news, like global economic data or earnings reports, outside regular hours meant that most of the benchmark’s 16% gain last year came in after-hours trading. All that then reduced the potential for trend followers to eke out gains during the cash session.

“It’s not a disappearance of momentum -- it was overnight momentum,” said Bolesta.

His program -- which bears a few differences from the bank products and trades a variety of stock indexes -- has returned an annualized 7% since its 2017 launch. After a strong first half, it dropped every month for the remainder of 2020.

Another theory: Option traders seemingly turned against momentum followers.

The likes of market makers and specialized funds typically hedge their option books as stock prices move, a practice known as gamma hedging. For example when the S&P 500 is plunging, these derivatives traders can intensify the selling by offloading shares to balance their exposures -- and vice versa.

But nowadays these dealers are buying and selling counter to the overall direction of the market, the theory goes. In options parlance, they’ve gone from negative gamma to positive. The market makers switched around April just as the S&P was beginning to recover from its historic rout, according to SocGen derivatives strategist Jitesh Kumar.

One explanation is that rising shares spurred dealers to hedge their exposures to bullish call options by shorting the market. Another holds that the decline of short-volatility strategies thanks to the pandemic rout may also be having an impact on hedging activity -- making traders less likely to fuel stock trends.

Keep the Faith

Even though it’s unclear what exactly is causing things to go awry, many quants are betting the strategy will pay off in the next downturn. It’s pattern that’s played out in the past. In the first quarter of 2020, the Deutsche Bank index jumped 20% before falling for the rest of the year. In 2008, it made 46%.

“The more realized volatility you have in prices, the less liquidity market makers will be willing to offer, and the more trends will be created during the day,” said Sandrine Ungari, head of cross-asset quant research at SocGen, which offers a version of the strategy.

Demand on Wall Street appears to be strong, with Deutsche introducing a variation of the trade that ends just before the U.S. close. Meanwhile Bolesta at Deep Field has retooled his to rider shorter trends, helping it fare better of late.

At Seven Investment Management in London, Matthew Yeates just recently invested in a bank-issued momentum strategy. Like many in the systematic world, he’s keeping the faith.

“When the market really moves on one big piece of news, that will likely propagate into the sort of distortions that help these strategies do well,” the head of alternatives and quantitative strategy said.

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